CF M&A

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VALUATION OF FIRMS INMERGERS AND ACQUISITIONS

Submitted to Prof. A. Chauhan

Corporate Finance - II

Vikas C.Chaubey

Roll No: 04/2010

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Flow of the presentationDefinition of M & A

Types of Mergers Firms valuation in Merger and

Acquisition

HP-Compaq Merger Case

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DefinitionsA merger is a combination of two or more

corporations in which only one corporationsurvives and the merged corporations go outof business.

Statutory mergeris a merger where theacquiring company assumes the assets andthe liabilities of the merged companies

A subsidiary mergeris a merger of twocompanies where the target companybecomes a subsidiary or part of a subsidiaryof the parent company

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Types of MergersHorizontal Mergers

- between competing companies

Vertical Mergers

- Between buyer-seller relation-ship companies

Conglomerate Mergers- Neither competitors nor buyer-seller relationship

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Motives and Determinants ofMergers Synergy Effect

- Operating Synergy- Financial Synergy

Diversification

Economic Motives- Horizontal Integration

- Vertical Integration

- Tax Motives

NAV= Vab (Va+Vb) P E

Where Vab = combined value of the 2 firms

Vb = market value of the shares of firm B.

Va = As measure of its own value

P = premium paid for B

E = expenses of the operation

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FIRM VALUATION INMERGERS AND ACQUISITIONS

Equity Valuation Models

- Balance Sheet Valuation Models Book Value: the net worth of a company as shown on the

balance sheet.

Liquidation Value: the value that would be derived if the firmsassets were liquidated.

Replacement Cost: the replacement cost of its assets lessits liabilities.

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FIRM VALUATION IN MERGERSAND ACQUISITIONS-2

Dividend Discount Models

31 2

0 2 3.......

1 (1 ) (1 )DD DV

k k k!

Where Vo = value of the firm

Di = dividend in year I

k = discount rate

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The Constant Growth DDM2

0 00 2

(1

) (1

) ......1 (1 )

D g D g Vk k

!

And this equation can be simplified to:

0 1

0

(1 )D g D

V k g k g

! !

where g = growth rate of dividends.

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FIRM VALUATION IN MERGERS

AND ACQUISITIONS-4

Price-Earnings Ratio

0

1

11

/

P PVGO

E k E k

!

-

where PVGO = Present Value of Growth Opportunity

0 1

1

(1 )P E b

E k ROExb

!

Implying P/E ratio

0

1

1P b

E k ROExb

!

where ROE = Return On Equity

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Cash Flow Valuation Models

- The Entity DCF Model : The entity DCF model values the value of a company as

the value of a companys operations less the value of debt and other investor claims,such as preferred stock, that are superior to common equity

. Value of Operations: The value of operations equals the discounted value of expected

future free cash flow.

.

Net Operating Profit - Adjusted TaxesContinuing Value =

WACC

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What Drives Cash Flow and Value?

- Fundamentally to increase its value a company mustdo one or more of the following:

. Increase the level of profits it earns on its existingcapital in place (earn a higher return on investedcapital).

. Increase the return on new capital investment.

. Increase its growth rate but only as long as the returnon new capital exceeds WACC.

. Reduce its cost of capital.

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FIRM VALUATION IN MERGERS

AND ACQUISITIONS-7

The Economic Profit Model: The value of acompany equals the amount of capital invested plus a

premium equal to the present value of the value created eachyear going forward.

Pr ( ) Economic ofit Invested Capital x ROIC WACC!

where ROIC = Return on Invested Capital

WACC = Weighted Average Cost of Capital

Pr ( ) Economic ofit NOPL AT Invested Capital x WACC!

where NOPLAT = Net Operating Profit Less Adjusted Taxes

Value=Invested Capital+Present Value of Projected Economic Profit

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STEPS IN VALUATION

Analyzing Historical Performance

NOPLATReturn on Investment Capital =

Invested Capital

FCF = Gross Cash Flow Gross Investments

Economic Profit = NOPLAT (Invested Capital x WACC)

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STEPS IN VALUATION-2 Forecast Performance- Evaluate the companys strategic position, companys

competitive advantages and disadvantages in theindustry. This will help to understand the growthpotential and ability to earn returns over WACC.

- Develop performance scenarios for the company andthe industry and critical events that are likely to

impact the performance.- Forecast income statement and balance sheet line

items based on the scenarios.

- Check the forecast for reasonableness.

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STEPS IN VALUATION-3 The Arbitrage Pricing Model (APM)

1 1 2 2( ) ( ) .... s f f f k r E F r E F r F F ! - -

where E(Fk) = the expected rate of return on a portfolio that mimics the kth factor and is

independent of all others.

Beta k = the sentivity of the stock return to the kth factor.

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STEPS IN VALUATION-4 Estimating The Continuing Value- Selecting an Appropriate Technique

. Long explicit forecast approach

. Growing free cash flow perpetuity formula

. Economic profit technique

T+1 T+1Economic Profit (NOPLAT )( / )( )

CV = +( )

g ROIC ROIC WACC

WACC WACC WACC g

where

Economic Profit T+1 = the normalized economic profit in the first year after the explicit

forecast period.

NOPLAT T+1 = the normalized NOPLAT in the first year after the explicit forecast period.

g = the expected growth rate of return in NOPLAT in perpetuity

ROIC = the expected rate of return on net new investment.

WACC = weighted average cost of capital

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STEPS IN VALUATION-5Calculating and Interpreting Results

- Calculating And Testing The Results

- Interpreting The Results Within The

Decision Context

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HP-COMPAQ MERGER CASEThe HP/Compaq merger. By The Numbers:HIGH-ENDHigh-end Unix Servers: Worldwide (2000)

FactoryRevenues ($m) Market Share

Hewlett-Packard 512 11.4%

Compaq 134 3.0%

Closest Rival: Sun Microsystems with factory revenues of$2.1 billion and a 47.1% market share

High-end Unix servers: US (2000)



Compaq 66 3.3%

Closest Rival: Sun Microsystems with factoryrevenues of $1.2 billion and a 60.1%market share

MID-RANGE

Mid-range Unix servers: Worldwide (2000)


Hewlett-Packard 3,673 30.3%

Compaq 488 4.0%

Closest Rival: Sun Microsystems with $2.8 billion infactory revenue and a 23.5%market share

Mid-range Unix servers: US (2000)



Compaq 296 5.4%

Market Leader: Sun Microsystems with revenues of $1.7billion and a 30.5% market share)

PERSONAL COMPUTERS

PC Shipments: Worldwide (in thousands of units)

Hewlett-Packard Compaq

Units (q2/01) 2,065 3,590

Share (q2/01) 6.9% 12.1%

Units (q2/00) 2,260 4.011

Share(q2/00) 7.4% 13.2%

Growth -8.6% -10.5%

PC Shipments: US(in thousands of units)


Units (q2/01) 991 1,332

Share (q2/01) 9.4% 12.7%

Units (q2/00) 1,221 2,293

Share(q2/00) 10.7% 20.1%

Growth -18.8% --21.3%

Market leader: Dell Computer Corp. with a 24% marketshare and a 9.8% growth in the same period.

LAPTOPS/NOTEBOOKS SMART HANDHELDS

Worldwide shipments of portable computers(thousands of units)


Units(q4/00) 318 817

Share(q4/00) 4.5% 11.6%

Units(q4/99) 139 739

Shipments(in 000s)

Share2000 Rank

Hewlett-Packard 254 3.8% 4

Compaq 129 1.9% 9

Market Leader: Palm with a 52.9% market share and

3.53 million units.

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HP-COMPAQ MERGER CASE-2Arguments About The Merger

- Supporters

. HP-COMPAQ will become the leader in most of thesub-sectors

. Ability to offer better solutions to customers demands

. New strategic position will make it possible to increaseR&D efforts and customer research

. Decrease in costs and increase in profitability

. Financial strength to provide chances to invest in newprofitable areas

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HP-COMPAQ MERGER CASE-3Arguments About The Merger

- Opponents

. Acquiring market share will not mean the leadership

. No new significant technology capabilities added to HP

. Large stocks will increase the riskiness of thecompany (Credit rating of the HP is lowered after themerger announcement)

. Diminishing economies of scale sector which bothcompanies have already a great scale.

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HP-COMPAQ MERGER CASE-4 Valuation Process

- Relative Historical Stock Price Performance

Historical Exchange Ratios

Period ending August 31,

2001

Average Exchange Ratio Implied Premium (%)

August 31 2001 0.532 18.9

10-Day Average 0.544 16.3

20-Day Average 0.568 11.3

30 Day Average 0.573 10.3

3 Months Average 0.557 13.7




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HP-COMPAQ MERGER CASE-5 Comparable Public Market Valuation Analysis

Firm Values As a Multiple of Revenue EBITDA and LTM EBIT

Firm Values as a Multiple of

Companies LTM Revenue LTM EBITDA LTM EBIT

Compaq 0.5 X 5.7 X 9.8 X

HP 1.0 X 12.4 X 19.8 X

Selected Group 0.2-2.1 X 5.3-18 .2 X 8.9-19.9 X

Closing Stock Prices As a Multiple of EPS

Closing Stock Price as a Multiple of

Companies 2001 EPS 2002 EPS 2003 EPS

Compaq 34.3 X 18 .4 X 14.0 X

HP 35.7 X 19.2 X 12.5 X

Selected Group 18 .5-57.3 X 10.7-27.1 X 9.3-19.5 X

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HP-COMPAQ MERGER CASE-7 Pro Forma Earnings Per Share Impact to Compaq

Accretion/Dilution Analysis

Accretion/Dilution

EPS

2002

EPS

2003

Compaq stand-alone 0.67 0.88

HP stand-alone 1.21 1.86

Combined entity pro-forma, excluding proj. synergies 0.74 1.09

Combined entity pro-forma, including proj. synergies 1.05 1.51

Accretion/(Dilution) to Compaq, excluding proj. synergies 11% 24%

Accretion/(Dilution) to Compaq, including proj. synergies 57% 71%

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ConclusionMergers and acquisitions is one of the best

processes of corporate restructuring that

has gained substantial prominence in the

present day corporate world. Restructuring

usually means major changes and

modifications in the corporate strategies and

beliefs. This shift in strategic alliances is

done with a desire to have an edge over

competitors, eventually creating a new

economic paradigm.

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References Http://www.google.com

http://www.wikipedia.org

http://www.kpmg.com

Corporate Finance by Khan and Jain

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Thank you!

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